Real Estate Home Mortgages/What Type of Loan Should I Get
QUESTION: My wife and I will be purchasing a new home in the next few months and need some advice on what type of mortgage to get. I will be getting a 5% down, conventional loan and am debating on whether to get a 30-year fixed rate or an ARM (5/1, 7/1, 10/1). I realize many people will say that the interest rates are so low right now that I should go for the 30-year fixed. My only hesitation in doing so is that I donít believe this will be the last home we will buy. I know we will be living in this home for at least 5 years but beyond that, I canít say for certain. The thought has crossed my mind to turn this home into a rental property once we decide to move again but am not sure if I want to be a landlord or pay a property management company. Another thought crossed my mind that if we do have a child while in this home, we may want to stay put longer.
In any case, I need some honest feedback/advice on whether it is worth it to roll the dice on an ARM or play it safe with a 30-year fixed given the information above? I have been told that because the interest rate is lower in the beginning on an ARM, that more is applied to the principal in the early years of the mortgage as opposed to a 30-year fixed where most of the payment in the early years goes towards interest. Letís say we donít decide to move away after 5 years or do turn it into a rental, better to take the chance with the ARM and refi to a fixed rate later if necessary? Or would we save more money in the long run by going with a fixed rate from the get-go? Which AR do we go with if we go that route (5/1, 7/1, or 10/1)? I appreciate your feedback on this. Thank-you.
ANSWER: Hi Mike -
thank you so much for the question! I am going to do my best to answer this question as best I can without having reviewed any information pertinent to your personal situation (ie: I do not have any of your income, asset, credit documentation). That being said, I would advise going with a fixed rate loan for a number of reasons.
1. It does not sound like you know how long you plan on keeping the home and there are a number of factors that may contribute to that decision such as having a child, converting your home to a rental property, etc. So, from the very beginning you are rolling the dice on time frames.
2. If you do plan on keeping the home, taking a lower interest rate now to plan on refinancing is not something I would suggest. We are still at historically low interest rates and I would not count on them remaining low for years to come.
3. You stated that you know you will be living in the home for at least 5 years which would lead me to suggest, if you were to go with an ARM, a term of at least 7 years. The 7 Year ARM rates that I show today will cost you to obtain that loan. If you were to compare the 7 Year ARM (which today costs about 0.75% at 4% per one lender) your payment per $100,000 is roughly $478. Comparing the same cost per rate (0.75%) on the fixed program would yield you an interest rate of 4.25% with the same lender which raises your payment only $14 per $100,000 borrowed. The difference between the 10 year ARM rate and the comparable cost or credit for the fixed rate is nearly identical to that of the 7 year ARM.
4. If you were to stay in the home for say, 5 years, and then convert it to a rental, you run the risk of not being able to take advantage of an owner occupancy status on a new mortgage.
Of course there is no "right" answer and it has to make sense for you and your financial situation. I am not sure if I explained everything clearly so please feel free to ask follow up questions.
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QUESTION: Thank-you for such a detailed response Sadie. I will try to give you a clearer picture by giving you some relevant information. My gross annual salary is $85,000 with $890 in monthly debt obligations (car loan, student loans, etc.) I am looking at a purchasing a home with the max sale price of $280,000, but likely less. This will be a new home construction.
I'm not certain if I want to become a landlord. I obviously like to idea of passive income, who doesn't. But I'm not sure I'm cut out to deal with potential legal issues with tenants, such as evictions, non-payment of rent, etc. I could hire property management which will cut into my bottom line. Do you have any experience with being a landlord or hiring a property management company that you can share with me? Under #4 of your original response to me, you said, "If you were to stay in the home for say, 5 years, and then convert it to a rental, you run the risk of not being able to take advantage of an owner occupancy status on a new mortgage." What do you mean by this?
When I calculated the difference between 0 point loans online, the difference in payment from a 5/1 ARM to a 30-year fixed was a savings of $223.00 per month. That's a fair amount to save each month. The ARM may even enable me to make bi-weekly payments rather than monthly payments to pay down the principal faster. I'm really on the fence.
My current life trend has been frequent relocations by choice, so that is the only reason I am even considering an ARM. If I don't turn this place into a rental, then I may be even more inclined to do the ARM. The savings are enticing, but I want to make the most financially-responsible choice. If that is the 30-year fixed, then so be it.
ANSWER: Thank you for the additional information, it can be helpful. The information your provided at least demonstrates to me that you have some options within your lend-ability, which is great.
The decision to become a landlord or not is certainly not something I can make for you. I do think that real estate investments tend to be a safe decision (with the understanding that the last 8 years or so have been unique) and I advise people to become landlords quite frequently. You do have legal requirements to which you may be interested in taking a few beginners courses on property management or, like you said, hiring a property manager (although I do not think that is necessary). There is the option of hiring a property manager for specific tasks, such as finding you a tenant, where you pay a flat fee and are not required to pay out of your rental income each month. This may help you with screening potential renters should the time come. I do have a little property management experience, nothing official, I simply suggest to accept highly qualified, prescreened applicants with stable income, good credit and good references.
What I meant by response under #4 was simply that IF you were to go with an ARM loan, converted your home into a rental property, and THEN tried to refinance, your loan would be considered an investment property as opposed to a primary residence. A loan on your primary residence will have better interest rates then an investment property. If you were to take out a fixed rate mortgage now and convert the property to a rental property down the line, you would not have this issue because your existing loan would already be in place.
I would be cautious with comparing interest rates online. Any time you see something advertised as a "0 points loan," it is pretty safe to assume that the interest rate will be higher than what is really going on. Nobody works for free and "0 points loans" are a bit misleading, the lender is getting their funds somewhere, you just don't see it. It is likely hidden in a higher interest rate. I am not sure if you are already working with a lender or a mortgage broker, but it is difficult to speak hypothetically. The best advice that I can provide so that you can make sure you are making an appropriate decision for yourself would be to ask your broker/banker for the following information on the 5/1 ARM, 7/1 ARM, 10/1 ARM and the 30 year fixed:
1. What is the cost or credit for the specific interest rate? (a cost is what you will pay to obtain the interest rate, a credit is what you will being given back for taking a specific interest rate). There are pros and cons to both costs and credits and you should be provided clarification if you have questions regarding these.
2. What is the principal and interest payment on each loan?
3. What is the recovery turn time? In other words, say you choose to go with the 5/1 ARM vs. the 30 year fixed because you are saving (as in your example) $220 per month. Now, let's say for the sake of argument that it costs you $3,000 more to obtain that loan vs. the fixed rate loan. Your recovery turn time for the $3,000 cost is just under 14 months ($3000 divided by $220), that would be a logical choice IF you KNOW you are going to sell before, or shortly after the loan becomes adjustable.
The best advice that I can give you is to make a choice that makes sense to you and that you feel comfortable with. It is YOU who has to live with it, not your lender. Advice is good to have and professionals should be able to provide you with logical advice, but the ultimate decision is yours to make.
Having ALL the information can help you make an informed decision. If your broker of lender cannot provide you this information, you should find one who can! I hope that is helpful, feel free to ask more!
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QUESTION: I sincerely appreciate the feedback Sadie. I do understand that the 30-year-fixed loan would offer the stability of a fixed, predictable payment, and that interest rates are surely to rise in the coming years. However, I am still on the fence as to whether this is the best option. I could always get a 7/1 or 10/1 ARM I suppose. Here are my thoughts and questions.
Wouldn't it be better to take a 5/1 ARM which will save me around $220 per month on my mortgage and apply that savings as extra payments toward the principal of the loan over the initial 5-year fixed rate period? I'm thinking that will enable me to pay down the principal faster while simultaneously eliminating the PMI at a faster rate as well. Also, even if the rate adjusts, I feel like with a lower principal and the rate adjustment cap, it may still benefit me more to do the ARM?
I've looked at an amortization schedule online that compared the 5/1 ARM and 30-year fixed loans that I have been looking at. While the 30-year-fixed resulted in more savings if the loan is carried to the full 30-year term, the 5/1 ARM saved more money on the total cost of the mortgage through year 20. It was only in year 21 that the fixed-rate began to have a lower overall cost. How realistic is it that I or anyone carries there loan to a full 30-year term?
That is why this decision is difficult for me.
Again, thank-you for your assistance. It is greatly appreciated.
It seems as though you have certainly done your homework and if the break even point between an ARM and a Fixed rate mortgage is 20+ years, then I would say that your logic is right on track. Although some people do hold their loans for the full term, the reality is that most people either sell their home or refinance well before year 30. Again, I would certainly say to go with what is the most comfortable to you, but your reasoning is valid.
I can tell you that for me, personally, if I could see a savings on something for 20 years I would likely take that option. Just make sure to carefully review the annual adjustment caps and max overall adjustments prior to agreeing to an ARM.